- Your mortgage loan
When it comes to getting a mortgage, there are many aspects to obtaining your financing. To start, there are many products to choose from such as fixed or variable rate mortgages and interest only plans. Each loan has a different structure and terms of repayment.
In the case of an interest-only ARM, you get a variable mortgage that starts out as interest-only. To understand this offering, it helps first to be familiar with the adjustable rate mortgage (ARM).
All adjustable mortgages begin with fixed payments for some years, before the interest rate starts to fluctuate. Once the loan becomes variable, your payments could go up or down without much notice. While that can sound alarming, many homebuyers can benefit from a loan with a variable interest rate.
- How does an ARM work?
An adjustable rate mortgage comes with a few defining characteristics. First, is the initial period of fixed payments, resembling a conventional mortgage. The interest rate for your introductory period is based on your credit profile and the property in question, among other variables.
This initial period generally ranges from 1 to 10 years. However, the starting interest rates are usually lower for a variable mortgage than a similar fixed mortgage. As a result, a creditor may have stricter qualification criteria for this type of loan.
Afterwards, two features will influence your interest rate adjustments: the margin and an index. Once the adjustments begin, your creditor adds the index to your margin, to get your fully indexed rate.
The margin is a base percentage that creditors use to set your interest rate. Generally, margins can go up to 3% but will vary by lender. Once you agree to a margin, it will be used a basis for all your rate adjustments.
The index is a general rate that banks use to lend money to other banks or creditors. This performance of the index tends to fluctuate based on various economic factors. Your creditor may have their own index or use common ones like LIBOR, COFI, and CMT securities. It’s vital to know which one your loan follows, as it gets added on to your margin.
Though an ARM can be unpredictable, most borrowers choose this mortgage for the lower initial payments. As a safeguard, it's possible to establish rate caps, so your payments don't increase too much. To reduce your expenses even further, you could set up an interest-only payment plan.
- What is an interest only ARM?
An interest-only ARM is a variable rate mortgage where you only pay the interest for the fixed period of the loan. That means you will owe the same amount of money you borrowed from the creditor once the rate begins adjusting at 5, 7, or 10 years. With interest-only payments, you don’t buy down your principal balance.
After the interest-only period, the loan structure changes, so the mortgage gets paid back entirely by the end of the term. That means your monthly payments will increase significantly, even if your index stays relatively the same, because of lost time.
For example, let’s look at a 10/1 ARM for a loan amount of $250,000 at 4% interest.
The starting monthly payment on the ARM works out to $1,194. By contrast, an interest-only payment plan produces an initial monthly payment of only $834. That equates to monthly savings of $360, or yearly savings of $4,320. After 10 years, that works out to $43,200 saved. As you can see, the results are quite remarkable.
After that point, the adjustments begin and the borrower can see his or her payments rise dramatically. With a standard ARM, the first adjustment may move the monthly payment to $1,225 and could eventually climb to a maximum of $1,683. Conversely, the interest only-mortgage will jump up to $1,548 at the first adjustment and could continue to rise to $1,911 per month.
Which begs, the question – do the initial savings really pay off? When all is said and done, the total cost of a fully amortizing ARM is approximately $507,802. Meanwhile, the interest-only ARM works out to a total of $520,988, which is $13,186 more than the fully amortizing counterpart.
As you can see, getting out at the right time could save a ton of money on your mortgage payments.
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- Is an interest-only ARM right for me?
Many homebuyers choose an interest-only mortgage for the immediate savings. Homeowners can save hundreds of dollars a month and thousands of dollars each year. However, for these loans to make sense, most applicants have to refinance, sell the home, or pay down the balance before it becomes adjustable.
Homeowners that know they will refinance their mortgage in coming years will likely be interested in an interest-only ARM. For this to work the borrower would have to maintain their creditworthiness. Unfortunately, it is never guaranteed that you will be a qualified applicant in the future. Property values can decrease, and interest rates can increase making it difficult for some to refinance. Homeowners that are expecting an increase in their credit score or earnings are more likely to benefit from this option<
An interest-only ARM can be beneficial when the borrower plans to move and sell the property in a few years. If you know your time in the home will be short-lived, interest-only plans can provide the lowest mortgage payments. However, depending on the market you may only make enough from the sale to pay off your balance. That could put a homeowner in a difficult situation if he or she doesn’t have much saved up for their next home purchase.
An interest-only ARM can also be appropriate for a homeowner that is purchasing a second property while planning to sell his or her primary residence. Some homeowners will keep the primary home for the whole interest-only period. As the initial period reaches maturity, the first home then gets sold. The proceeds from the sale can be used to pay down the principal balance. Even if the principal isn’t entirely paid off, the homeowner gains the advantage to refinance and negotiate better terms.
The major downfall of the interest-only mortgage is the fact that you will still owe the same amount of money after your payment plan ends. It's wise to have concrete plans for the future, along with a backup plan should specific factors come into play.
- Using the calculator
The calculator is very simple to use. It is designed to illustrate the savings and obligations of an interest-only ARM. You’ll have to add your financing needs, to get an accurate depiction of the monthly expenses. Let’s review this together.
Step 1. In the first section of the calculator, you can include your financing needs. Start by adding the dollar amount you need to borrow on the first line of the calculator. You can use your keyboard or the arrow features to make this input easier.
Step 2. On the second line of the calculator, using the drop-down menu, select the type of ARM you would like. The first number refers to the years of fixed payments, while the second number refers to the years between adjustments. That means a 10/1 ARM has ten years of fixed payments followed by yearly rate adjustments.
Step 3. Next, you can choose how you would like to view your report. Select a monthly or yearly breakdown next to report amortization.
Step 4. In the next section, you can add the specifics of your adjustable rate mortgage. You can change the months between rate adjustments if it differs from the drop-down in step 2.
Step 5. On line six of the calculator, you can add the expected rate adjustments. Your creditor should be able to give you an estimate of how much your rate will change at each adjustment. You can always refer to the historical data from the index to see how much the rate tends to move around.
Step 6. Finally, you can add an interest rate cap. If you set this number to 8%, it means your interest rate will never go above 8%.
- Your results
Once the questionnaire is completed, you can view your results in the form of smart prompts and integrated reports.
Immediately to the right of the inputs, you can find a summary of the interest-only ARM costs. Here you can see details such as your starting monthly payment and the maximum payment monthly payment you may experience. Just below that, you can find information on your total payments and interest for this loan.
For more details, you can move on to the integrated reports.
The first tab provides a chart of the mortgage amortization, where you follow along with your balance over time. You can get an exact reading of the remaining balance on the loan by holding your mouse over the chart.
The second tab provides a breakdown of how much money is spent on the principal in green, versus interest in blue. When you get an interest-only mortgage, it tends to costs you more over time than a fully amortizing mortgage.
The third tab, monthly payments, provides a neat summary of your adjustable rate mortgage, including the maximum possible payment.
Finally, the last tab will give you an itemized summary of all your payments over the life of the loan. You can switch between monthly and annual reports without losing any of your information.